Small real estate investors might miss out on new federal tax deduction

Small real estate investors might miss out on new federal...

1of2A for-lease sign is posted in front of home for rent in San Francisco. It’s unclear if investors who hold just one or two rental properties will qualify for a major new federal tax deduction.Photo: Justin Sullivan / Getty Images 2015

2of2Not all real estate investors will get benefits under the federal tax law passed in December.Photo: Chris Bosak / Hearst Newspapers

People who own just one or two rental properties might not qualify for the new 20 percent federal deduction that big-time real estate investors and other pass-through entities will get starting this year.

The federal tax law passed in December lets many pass-through entities such as partnerships and sole proprietorships deduct 20 percent of their “qualified business income,” with some limits. These are called pass-throughs because the business pays no taxes. Instead, income flows through to the owners and is taxed at their personal rates. The vast majority of U.S. businesses are pass-throughs.

This groundbreaking provision raised a host of complicated questions, including how income from rental property would be treated.

On Aug. 8, the Internal Revenue Service proposed regulations for the pass-through provision, known as the Section 199A deduction. But they provided few definitive answers for real estate.

To qualify for the deduction, it said an activity must rise to the level of a “trade or business,” an ambiguous term that has no clear or consistent definition in the tax code. The IRS said that for purposes of this deduction, it will look to section 162(a) of the tax code, which governs deductible business expenses.

A landmark Supreme Court decision said that to be a trade or business under Section 162(a), “the taxpayer must be involved in the activity with continuity and regularity” and that the “primary purpose” must be “income or profit.” It said a “sporadic activity” or hobby does not qualify.

The proposed regulations do not specify how many or what type of properties you’d need to own to qualify as a trade or business under this definition, except in one specific case: A business that owns property that it rents to itself can treat that property as a trade or business.

The proposed rules made it clear that if you own shares in a real estate investment trust — a pass-through entity that owns and manages large-scale properties — you can deduct 20 percent of your dividends.

But for property you own directly, it’s still an open question. “The regs really stink in this regard,” said Jeff Levine, director of financial planning with Blueprint Wealth Alliance.

One thing tax pros seem to agree on is that property rented on a triple net lease would not qualify for the deduction. This is a lease in which the owner collects rent and the tenant is responsible for everything including maintenance, property taxes and building insurance. Other than that, there’s little consensus as to what would or would not qualify.

Kenneth Weissenberg, head of real estate services for accounting firm EisnerAmper, said that if you own a 10-unit apartment building that requires ongoing maintenance and tenant dealings, you most likely would qualify, even if you have a property manager. “Work performed by a property manager (but not a tenant) qualifies as work performed by the owner,” he said.

If you own at least five units “you probably have a good shot” at qualifying, he said. Renting out half of a duplex, a cottage in the backyard or a single-family home you inherited probably would not qualify. A fourplex “is close to being a trade or business,” Weissenberg added.

Based on his reading of the regulations, Stephen Nelson, a CPA in Redmond, Wash., said, “I think (the deduction) applies when someone has several rental properties.”

Nelson said he assumed, “maybe naively,” that even a single rental property would qualify. “I thought because they would give you a deduction for REIT dividends, and a deduction if you invested in a real estate partnership, that they were going to help out the small guy and give you a deduction if you have a rental or a couple rentals.”

Levine said renting out half a duplex could qualify as a business, “but you would have to show it’s regular and continuing. You would need to document your hours and what needs to be done.” He added that a tax court judge could agree or disagree with this.

San Francisco CPA Richard Pon doesn’t think that even a five-unit building would pass the test. “To be a trade or business, there has to be a significant amount of work involved. I would say daily maintenance or security brought on by owners or actual employees would be required,” he said.

Mark Luscombe, principal federal tax analyst at Wolters Kluwer Tax & Accounting, said in an email that he discussed the proposed regulations with “some senior IRS personnel” at a recent tax conference. They indicated that they “have not yet decided how far to extend trade or business treatment to real estate rental activity. It was not their intent in the proposed regulations to treat all real estate rental activity as a qualifying trade or business.”

Real estate investment has always been a tricky business for the IRS, because “it doesn’t require a lot of day-to-day, hands-on activity,” said Dustin Stamper, a managing director with accounting firm Grant Thornton. “But that doesn’t mean it can’t be a trade or business.”

Elsewhere in the tax code, the IRS has established more specific and quantifiable regulations for real estate, such as the definition of a “real estate professional” and “material participation” in its passive-activity rules.

Many tax pros hoped the IRS would incorporate those rules — or some like it — into their proposed regulations for the pass-through deduction. They didn’t, but they could before the regulations are made final.

“It would be extremely helpful if they could come up with a similar test, an objective criteria rather than a subjective criteria,” said Bob Keebler, a CPA in Green Bay, Wis.

Real estate investors who do qualify for the deduction will still have to contend with some limits to the deduction that apply over certain income levels, but these rules are more generous for real estate than other types of businesses.

Kathleen Pender writes the Net Worth column in The San Francisco Chronicle. She explains how the big business and economic news of the day affect a household's net worth. She covers saving, investing, debt, taxes, housing, mortgages, retirement plans, employment and unemployment with a focus on issues specific to California and the Bay Area.

When it comes to big financial decisions, she believes that the simplest answer is almost always the best and that people would stay out of money trouble if they didn't get involved in things they can't understand. Pender welcomes questions from readers and frequently answers them in her column.

She majored in business journalism at the University of Missouri-Columbia and was a Knight-Bagehot fellow in business journalism at Columbia University.